Tax and estate planning: How do fund distributions affect ACB?

by Invesco Tax & Estate team, Invesco Canada

Most investors who hold funds (e.g., mutual funds and exchange-traded funds) in non-registered accounts are familiar with how purchases and redemptions affect their adjusted cost base (ACB). However, many are not aware of how distributions affect their ACB. Distributions can impact an investor’s ACB depending  on the income characterization of those distributions and whether they are reinvested or paid out in cash.

Generally, an investor’s ACB (sometimes referred to as the “tax cost”) is the sum of all the purchases in the fund and any expenses incurred for those purchases, such as commissions or sales charges¹, adjusted for certain corporate actions.

It is critical to know the ACB to calculate the capital gain or loss when the fund is disposed of or deemed to have been disposed of. When calculating capital gains and/or losses, it is important to track the distributions’ effect on the investor’s ACB to ensure the figure is up-to-date and accurate.

Return of capital distributions

A return of capital (ROC) distribution is not taxable in the year received, which distinguishes it from the following investment distribution categories: interest income, Canadian dividends (eligible and ineligible), foreign non-business income and capital gains. The distribution’s effect on an investor’s ACB will depend on whether the investor decides to receive the distribution in cash or reinvest the distribution in the fund.

ROC distributions taken in cash reduce the investor’s ACB by the amount of the distribution. ROC distributions that are reinvested also first reduce the ACB by the amount of the ROC distribution, but then increase the ACB by the amount of the reinvestment. The result is no impact on the total ACB; however, more units or shares of the fund are purchased.

When a ROC distribution taken in cash results in a negative ACB, the negative part of the ACB is immediately taxable as a capital gain in the year this occurs. The taxable portion is subsequently added back to bring the ACB up to nil (zero) to avoid any double taxation on future dispositions.

Income distributions

An income distribution is included in the investor’s income in the year received, regardless of whether the distribution is taken in cash or reinvested. Income distributions can be composed of interest income, Canadian dividends, foreign non-business income and/or capital gains. Annually, the fund will indicate the income characterization and the total sum of the fund’s distributions on the tax slip issued to the investor.

Income distributions are taxed according to their respective income categorization, following Canadian tax rules. For instance, Canadian eligible dividends are grossed-up and given a dividend tax credit, whereas interest income is fully included as income.

Since income distributions are taxable to the investor in the year they are paid, reinvested income distributions are not taxed twice because they increase the investor’s ACB. On the other hand, income distributions paid in cash will not affect the ACB.

For investors who hold ETFs, special attention should be paid to year-end reinvested distributions. These year-end distributions are commonly referred to as “phantom distributions” because the investor does not actually receive any cash or physically see any additional units.

Instead, the investor receives a notional distribution of new units that are immediately consolidated so the net asset value (NAV) and number of units are the same as they were before the distribution. Although the investor does not receive any cash or any actual new units, the phantom distribution is taxable to the investor in the year assigned and it is reported on the tax slip.

To avoid double taxation, the investor should therefore adjust the ACB by the amount of the income portion of the phantom distribution reported on the tax slip. We will discuss “phantom distributions” in more details in our next blog post of this series.

Why the NAV decreases after a distribution

Income and capital gains earned by a fund are added to the fund’s total assets throughout the year and reflected daily in the fund’s NAV. At the end of the year, or on an earlier distribution date, some or all of the income received, and the capital gains realized throughout the year (or in the period since the last distribution) are distributed to investors from the fund’s assets. The distribution of amounts from the fund’s assets generally lowers the NAV by the amount of the distribution to account for the decrease in the fund’s assets.

Example of the impact of fund distributions on ACB

Let’s assume a unitholder purchases two units of Fund A at $4 per unit for a total of $8. The $8 becomes the unitholder’s ACB, with an average cost per unit of $4 ($8 divided by 2 units). Then the unitholder receives a distribution of $0.03 per unit, comprising $0.01 ROC and $0.02 income. The total distribution received is $0.06.

Scenario 1: The entire distribution is taken in cash

• The $0.02 per unit income distribution has no effect on the ACB
• The $0.01 per unit ROC distribution reduces the ACB by that amount

No new units are purchased, since the distribution was taken in cash, so the new total ACB for the initial two units is $7.98. The new average cost per unit after the distribution is $3.99 (the initial total ACB ($8) less the total ROC distribution ($0.01 x 2) divided by the total units (2)). Alternatively, it can be calculated by taking the new total ACB ($7.98) and dividing it by the total number of units (2).

Scenario 2: The distribution is reinvested

• The $0.02 per unit income distribution increases the ACB by that amount and more units are acquired
• The $0.01 per unit ROC distribution reduces the ACB by that amount and then, once reinvested, increases the ACB by the same amount; the impact is no change to the total ACB, but more units have been acquired

The number of new units acquired depends on the NAV of the fund on the day of the distribution. If the NAV falls to $3.97, the investor will receive 0.01511 in new units ($0.06 divided by $3.97). The total number of units after the distribution will be 2.01511 units.

The new total ACB after the distribution is $8.04, calculated as the pre-distribution total ACB of $8 less $0.02 because of the ROC distribution plus $0.06 to account for the reinvestment of the entire distribution (ROC distribution and income distribution). With the receipt of 0.01511 in new units (based on a reinvestment price of $3.97 per unit), the new average cost per unit is $8.04 divided by the number of units (2.01511), which is $3.99. The total ACBs are different in the two scenarios since the unitholder does not receive new units in the first scenario, but receives 0.01511 new units in the second scenario. The average cost per unit will change depending on the amount of the reinvestment and the NAV per unit when the reinvestment is made. In the example given, we assumed no market fluctuation in the underlying investments and because the reinvested amounts are relatively small, the impact to the average cost per unit is negligible.

Summary – Impact of fund distributions on ACB

Distribution typeReinvestedCashROCACB decreases by the amount of the ROC distribution, then increases by the amount of the reinvested ROC distribution. No effect overallACB decreases by the amount of the ROC distributionIncomeACB increases by the amount of the income distributionNo effect

[1] Expenses such as commissions incurred on dispositions do not technically form part of the ACB, though they are valid outlays that may be deducted from the proceeds of disposition. This has the effect of reducing the capital gain or increasing the capital loss for income tax purposes. Also, the ACB is not to be confused with the security’s “book value” or position cost. The former may simply be the total of all cumulative purchases in the fund without regard for any reinvested distributions, corporate actions or adjustments to the ACB (such as for returns of capital). To be sure, investors should contact the institution providing the figure to determine the variables used to calculate the book value figure. The latter on the other hand, is a regulated figure specific to each security (or position) to give investors an idea of how the security has performed (in total dollar terms) relative to its market value.

This post was first published at the official blog of Invesco Canada.